Having established the way in which firms can initially raise equity capital, and then discuss the impact of debt on the amount and variability of the returns to shareholders. We'll spend our last session together surveying alternative explanations for why we observe different debt levels for firms that operate in different industries. As well as for firms that operate within the same industry. We're now going to shift focus to how firms decide upon the optimal proportion of their earnings they should return to shareholders, either in the form of dividends or via share repurchases. Now to set scene, let's first consider the inter-relatedness of the various decisions made by a firm by examining the firm's cash budget. The following cash budget begins with the cash flows generated by the firm's operating activities. If you like, it's net cash flows from its ordinary course of business. These cash flows will be supplemented by any cash flows that may result from the selling of assets, as in perhaps abandoning what were once profitable operations. We then subtract any cash flows that we distribute to the owners of the firm, via dividends or share repurchases. Now, share repurchases are where the firm enters the market to buy back its own shares. We then finally subtract any net debt repayment. Which reflects the net effect of issuing additional debt into the market, whilst also paying down our existing debt. The remainder represents the capital available to the firm for additional investment. Now a key point here is that the payout decision should not be viewed independently of the effects flowing from our other decisions, including our investment and financing decisions. Now over time, our hope is that the firm that we have invested in will increase in value. As it continues to take on positive MPV projects. Take, for example, Kellogg's share price. As it has continued to invest profitably, we've observed this generally increasing share price. Regularly, Kellogg's faces the decision about how much of those returns should be returned to shareholders in the form of a dividend. So when we consider the payment of the dividend there are three key events to take account of. Firstly, there's the dividend announcement. The dividend announcement date represents the date on which the market will perceive the announcement of the dividend as a signal as to the future prospects of the firm. So if the announcement is perceived as a positive signal, we'll see a share price increase. If it's perceived as a negative signal about the future prospects of the firm, then we'll see a negative adjustment to the share price. The second event is the ex-dividend date. On the ex-dividend date, the share begins trading without an entitlement to the dividend declared. So we expect to see, all other things being equal, a decrease in the value of a share. Representing the value of the dividend to shareholders. The third date is the dividend payment date. And we expect to see no systematic change in the share price on the dividend payment date. Because all the rights and entitlements to the dividend lapsed on the ex-dividend date itself. So with respect to Kellogg's dividend declared in 2012, we find a fall of approximately $0.43 on the dividend announcement date. We see a fall of $0.86 on the ex-dividend date. And finally, a very, very immaterial change in share price on the dividend payment date. An alternative to a dividend payment is a share repurchase, also known as a share buyback. This is where a company will use its cash to enter the market and repurchase its own equity. In some countries, the shares will be cancelled as in Australia. But in other countries they may be used or retained as treasury stock, and then paid out to executives as part of the compensation scheme. Let's consider the notion of payout irrelevance. Let's assume that a firm has 400,000 shares on issue, trading at $5.00 per share. Let's also assume that you own 4,000 shares, or 1% of the firm. The firm declares a dividend of $1 per share and immediately pays it out. So the share price on the ex-dividend date, which occurs immediately, should fall from $5 to $4 as those earnings are distributed to you. So what does your position look like before and after the declaration and payment of that dividend? Before you owned 4,000 shares trading at $5 per share, so the value of your share portfolio was $20,000. After the dividend is being paid, the value of your share portfolio has fallen to $16,000 which you now have cash in your pocket of $4,000. The total value of your portfolio still remains at $20,000. So through this analysis payout is completely irrelevant to you. Indeed the company didn't need to do a clearer dividend at all. You could have simply sold 800 of your shares at $5 per share, to have achieved exactly the same outcome on a before and after basis. Selling your shares, without a dividend being declared, is what's known as creating a homemade dividend. Let's look at this from the firm's point of view. Let's assume that having declared and paid out that cash as a dividend, the firm goes back into the market and issues 100,000 shares at $4 per share to recoup the cash it's already paid out. So from the firm's perspective, before the dividend was declared and paid, there was $2 million of assets all claimed by the old shareholders. Following the issuance of a dividend and the payment of the dividend, our old shareholders now own only $1.6 million of shares. But the firm has been able to recoup the additional $400,000 which was paid out as a dividend, and the total value of assets remains at $2 million. The payout is irrelevant to the value of the firm's assets. So why do firms behave as if payout policy is so important, when we've just demonstrated, with a very simple example, that it shouldn't matter to anyone? Well there's a number of reasons. The first suggested reason is the so called bird in the hand argument, also known as resolution of uncertainty. The idea being that the capital gains generated by a firm are more uncertain than dividends that are paid out. I prefer a dollar in my pocket in the form of a dividend, as opposed to a dollar in the share price. Which reflects the capital gain over the share in the intervening time. But as we just demonstrated with our example, you can resolve all uncertainty associated with your capital gains by simply selling some of your shares. That is, creating a homemade dividend. For this reason, it doesn't hold much validity. The second suggested reason, is associated with issuing transaction costs. A higher level of earnings payout implies more frequent capital raisings. And each time you go to the market to raise additional capital, you face additional costs such as perspectives preparation, lawyers, bankers, so on and so forth. Or indirect costs such as dilution in control, conditions enforced by debtholders, or loss of flexibility of the firm's operations. Now, the higher the level of these costs incurred, the lower the level of payout you might expect to see. The third reason put forward is known as information asymmetry and signaling. Once again, this relies upon an argument associated with the imbalance of information between management and the market. The consequence of that imbalance of information, is that the market is constantly looking for a signal by management about the future prospects of the firm. Consequently, management will be reluctant to decrease dividends for fear of the negative signal this sends about the future earnings of the firm. So this makes them reluctant to increase dividends until they're certain that they can maintain the increased amount. And this leads to what's known as a sticky dividend policy. If you look at the diagram on the top right of this slide, you see that dividends increase in a step-wise fashion. On the bottom diagram, you see earnings per share. Over a shorter period, but more volatile than dividends per share. Dividends only being increased when the firm is sure when they can maintain the increased payment amount. That is, earnings have increased to such a level that they can sustain a higher level of payout. For fear of having to reverse that decision down the track. Another reason has to do with agency problems. So managers acting as agents for the principals, the shareholders of the firm. Now, shareholders are concerned about funds being lost from money wasted on the consumption of perquisites, or money spent monitoring the behavior of management to make sure that they're not wasting the cash. So what's this got to do with payout policy? Well the idea is the higher the level of payout, the more frequent the company's going to have to go back to the capital market to raise new capital. As it goes back to the market to raise new capital, it'll be forced to tell the market what it's doing with its cash. And this gives a chance to shareholders to observe the behavior of management in a relatively cheap fashion. So in that sense, dividends paid out can act to soak up free cash flow. Make sure that there's not too much cash floating about for management to waste. Next, taxes. This is an extremely important point. When a firm pays a dividend, the share price falls to reflect that the funds have been distributed. So if you have a look at the illustration on the right hand side, we see with the blue line, a company that's declared a dividend and the share price has fallen. In the absence of that dividend, the share price would have continued to increase and maintained a level as signified by the red line. The difference between the two is simply the value of the dividend paid out. So from a shareholders perspective, payout policy is really just a question of whether you receive of your returns via increases in share price, that is capital gains, or via dividends. Now in many countries this is important because capital gains are taxed at a different rate to dividends. Especially for long-term capital gains. For example, in Australia capital gains generated over a period of more than a year, so you've owned the asset for more than a year, and taxed at only half the investor's marginal tax rate. And similar tax rules also relate to capital gains. Long term capital gains in the US. So what do managers tell us? When we ask them what factors influence your firm's decision about it's dividend policy? The number one reason is the ability of the firm to maintain the level of dividends paid out. That's consistent with the signalling hypothesis. The general reluctance by management to increase dividends too much in fear of having to reverse that decision. And then cop the negative consequence that goes along with that. Second reason is an associated one. The level of dividends paid out previously determines our current pay out rate. So that's also consistent with signaling. The third reason is surplus of funds that can't be invested in positive NPV projects. Identifying that free cash flows optimally should be passed back to shareholders. Tax reasons and the cost of replacing funds, transaction cost. Two reasons that fall in the end. So in summary, the payout policy of the firm is interrelated to the other decisions that the firm makes. It's a decision about what proportion of earnings should be distributed to shareholders. Which ultimately is a choice between capital gains, or cash payments to those shareholders. In the absence of transaction costs, information asymmetry, agency issues, or tax differences, payout policy, probably doesn't matter. It's probably irrelevant. Firms choose their payout policy carefully. And cite reasons for this that are consistent with the importance of possible signalling to the market, as well as managing investor expectations. So to summarize the module, so far we've taken a very insular view of the firm. How do we evaluate internally generated investment proposals? How do we determine our optimal investment strategy? In our next module, we're going to switch to an external focus for the organization, in both investment and risk management. We're going to begin to consider mergers and acquisitions. That is, how we can generate value for shareholders by investing externally to the firm. We'll consider corporate restructuring, creating value by divesting our assets externally. And finally, risk management, interacting with external markets to manage the risk of the firm's cash flows.
